History on the market’s side

You wouldn’t know it for all of the angst about Libya, oil, government debt and whatever else, but US stocks have reclaimed much of last week’s losses and today closed February with a 2.8 per cent monthly gain for the Dow Jones Industrial Average (and more than 3 per cent for the S&P 500).

History is now on the side of investors because taken together with January’s similar-sized gains, it is extremely rare for the US share market to start a year so strongly in the first two months and not produce a positive return for the full year.

In fact, of the 26 times since 1940 that the Dow Jones Industrial Average gained ground in the first two months of the year, only once - in 1974 - did it finish in the red.

Stocks are also now up for three months in a row and, incidentally, it will be interesting tomorrow to see if equities can continue their strong trend (in 14 of the last 16 months) of rallying on the first day of each new month.

Markets were calmer today than much of last week largely because oil prices stabilised - though it is worth noting stocks jumped in February despite the 6 per cent rise in crude in the past month.

Some investors today also took heart from Warren Buffett’s bullish weekend comments about America’s future, there was some more M&A activity and the Chicago PMI release was the highest since 1987.

Maybe the real hurdle for markets is not geopolitics - markets have always had to deal with such uncertainty - but how Federal Reserve policy plays out this year and how investors react to eventual policy normalisation.

This is not an immediate issue because though the recovery seems to be well under way and the Fed is thinking hard about unwinding its balance sheet and lifting rates, actual policy tightening is still some time off.

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No doubt Fed chairman Ben Bernanke will say as much when he fronts Congress tomorrow and Wednesday for his semi-annual Humphrey-Hawkins testimony.

Today St Louis Fed president James Bullard also gave a strong indication there would be no early end to QE2, or the second $US600 billion program of buying US government bonds due to end in June.

Meanwhile, his arguably more influential colleague at the New York Fed, William Dudley, sounded pretty dovish as per usual.

In fact, some (relatively mild) data disappointments in recent weeks - including spending and housing reports - may simply delay the Fed even longer from changing the course of policy, perversely underpinning stock prices.

Yet if you are assume investors are always looking at least six and possibly 18 months ahead, the market does need to adapt to the notion that ultra-easy money will end at some point over this sort of timeframe.

For one, QE2 will probably end in June - and the mere end of that program could arguably be categorised as a form of tightening - and QE3 looks unlikely barring any noticeable deterioration in the jobs market.

The tough bit is predicting the interplay between different markets as artificial policy stimulus, which has distorted prices across most asset classes, is unwound.

The start of QE2 back in November put a rocket under stocks and should have put a bid under Treasuries, but instead bonds sold off as the improved economic outlook became the strongest influence on markets.

Now we actually have some economists expressing second thoughts about the growth outlook - JPMorgan on Friday cut its March quarter GDP growth forecast to 3.5 per cent from 4 per cent. It is possible that this is merely a function of bad weather holding back consumer spending and that growth shortfall will just spillover into the June quarter.

Likewise, higher oil prices have everyone worried about inflation - which would force the Fed to tighten policy - but counter-intuitively higher oil prices look more likely to suppress spending and act as a deflationary influence, keeping the Fed’s foot off the monetary brake pedal.

A lot hinges on Friday’s payrolls data, which is being talked up as a good report (with up to 200,000 new jobs being forecast by some economists) and therefore leaves a reasonable scope for disappointment.

The upshot is there’s enough uncertainty to keep the Fed sounding dovish for the foreseeable future.

The really curious thing about the current market is that despite the rumblings in the Middle East and Europe’s ongoing problems highlighting the safe-haven status of the US, the greenback is struggling to gain much ground.

But the weakness in the US dollar - which hit a four-month low today - is easily explained by hawkishness in Europe attracting dollars there, though you have to question whether the Europeans seriously want to raise rates given the state of the continent’s economy.